Managerial Economics &
Business Strategy
Chapter 3
Quantitative Demand Analysis
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
3-2
Overview
I. The Elasticity Concept
• Own Price Elasticity
• Elasticity and Total Revenue
• Cross-Price Elasticity
• Income Elasticity
II. Linear Demand Functions
3-3
The Elasticity Concept
• How responsive is variable “G” to a change in variable “S”, i.e. it is a
measure of the responsiveness of one variable to changes in another
variable; the percentage change in one variable that arises due to a
given percentage change in another variable.
%G
EG , S
%S
If EG,S > 0, then S and G are directly related.
If EG,S < 0, then S and G are inversely related.
If EG,S = 0, then S and G are unrelated.
• Since % ∆ G = ∆ G/G and % ∆ S = ∆ S/S
• Two aspects of an elasticity are important: (1) whether it is positive or
negative and (2) whether it is greater than 1 or less than 1 in absolute
value. The sign of the elasticity determines the relationship between
G and S. If the elasticity is positive, an increase in S leads to an
increase in G. If the elasticity is negative, an increase in S leads to a
decrease in G.
3-5
Own Price Elasticity of Demand
d
%QX
EQX , PX
%PX
• It measures the responsiveness of quantity demanded to a change in price.
• Negative according to the “law of demand.”
Elastic: EQX , PX 1
Inelastic: EQX , PX 1
Unitary: EQX , PX 1
3-6
Perfectly Elastic &
Inelastic Demand
Price Price
D
Quantity Quantity
Perfectly Elastic ( EQ X ,PX ) Perfectly Inelastic ( EQX , PX 0)
• perfectly elastic: in view of the • Perfectly inelastic:
pandemic and contagion of
• Like a life-saving drug
COVID’19, most of the people opted
for personal transportation for
safety reasons instead of public
transportation to commute.
Consequently the demand for the
personal transport vehicles like
bikes and cars has increased though
there was no change in the price of
personal transportation vehicles in
the market.
3-8
Own-Price Elasticity
and Total Revenue
• Elastic
• Increase (a decrease) in price leads to a decrease (an increase) in total
revenue.
• Inelastic
• Increase (a decrease) in price leads to an increase (a decrease) in total
revenue.
• Unitary
• Total revenue is maximized at the point where demand is unitary elastic.
Rule: EQx, Px = (∆Qx d/∆Px)(Px /Qx )
Price Quantity Elasticity [Link]
a 0 80 0 0
B 5 70 -0.14 350
C 10 60 -0.33 600
d 15 50 -0.6 750
e 20 40 -1 800
3-10
Elasticity, Total Revenue and Linear Demand
P TR
100
Elastic Unit elastic
Unit elastic
80
60 1200
e
Inelastic
40
20 800
0 10 20 30 40 50 Q 0 10 20 30 40 50 Q
Elastic Inelastic
The total revenue test
At points to the northwest of E, demand is elastic and total revenue decreases as price increases. At points to
the southeast of E, demand is inelastic and total revenue increases when price increases. This relationship
among the changes in price, elasticity, and total revenue is called the total revenue test.
3-12
Demand, Marginal Revenue (MR) and Elasticity
P • For a linear inverse
100 demand function,
Elastic
80 Unit elastic MR(Q) = a + 2bQ,
60
where b < 0.
Inelastic • When
40
• MR > 0, demand is
20 elastic;
• MR = 0, demand is unit
elastic;
0 10 20 40 50 Q • MR < 0, demand is
inelastic.
MR
• Marginal revenue (MR) is the change in total revenue due to a change
in output, and that to maximize profits a firm should produce where
marginal revenue equals marginal cost.
Factors Affecting 3-14
Own Price Elasticity
• Available Substitutes
• The more substitutes available for the good, the more elastic the
demand.
• Time
• Demand tends to be more inelastic in the short term than in the
long term.
• Time allows consumers to seek out available substitutes.
• Expenditure Share
• Goods that comprise a small share of consumer’s budgets tend to
be more inelastic than goods for which consumers spend a large
portion of their incomes.
Cross Price Elasticity of Demand
• It is a measure of the responsiveness of the demand for a good to
changes in the price of a related good; the percentage change in the
quantity demanded of one good divided by the percentage change in
the price of a related good.
3-16
Cross Price Elasticity of Demand
d
%QX
EQX , PY
%PY
If EQX,PY > 0, then X and Y are substitutes.
If EQ < 0, then X and Y are complements.
X,PY
• Cross-price elasticities play an important role in the pricing decisions
of firms that sell multiple products. Indeed, many fast-food
restaurants offer hamburgers for under $1.00 because their managers
realize that hamburgers and sodas are complements: When
consumers buy a hamburger, a soda typically accompanies the
purchase. Thus, by lowering the price of burgers, a restaurant affects
its revenues from both burger sales and soda sales. The precise
impact on these revenues depends on the own price and cross-price
elasticities of demand.
Income Elasticity
• It is a measure of the responsiveness of consumer demand to changes
in income. d
%QX
EQX , M
%M
If EQ > 0, then X is a normal good.
X,M
If EQX,M < 0, then X is a inferior good.
• Other elasticities is deleted
• Elasticities for Nonlinear Demand Functions is deleted
• Regression analysis is deleted
OBTAINING ELASTICITIES FROM
DEMAND FUNCTIONS
• Elasticities for Linear Demand:
• If the demand function is linear and given by:
Qx d = a0 + axPx + ayPy + aMM + aHH
the elasticities are:
own price elasticity: ax (Px/ Qx)
cross-price elasticity: ay (Py/ Qx)
income elasticity: aM (M/ Qx)
3-21
Uses of Elasticities
• Pricing.
• Managing cash flows.
• Impact of changes in competitors’ prices.
• Impact of economic booms and recessions.
• Impact of advertising campaigns.
• And lots more!